4 Categories of Financial Ratios

To help gauge the progress and overall financial health of your small business, basic familiarity with a number of accounting procedures is necessary. One area of accounting involves the use of financial ratios, which can point out financial trends or indicate areas that need improvement. Work closely with an accountant to gain an understanding of what your particular ratios mean to your business.

Growth Ratios

Growth ratios can give an indication of how fast your business is growing. For example, one type of growth ratio is sales percentage, which compares current sales to those of the previous year. Net income percentage takes sales growth a step further by showing profit after subtracting operating costs. It could be possible that even though the sales percentage indicates that sales have increased by 30 percent, your net income percentage may have increased only by 20 percent because of increased operating costs.

Ratios of Financial Condition

Ratios of financial condition indicate the overall financial health of a business. For example, debt-to-equity ratio compares the amount of incurred debt, such as business loans and credit card balances, to the amount of equity, such as the amount of business assets you hold. The lower the debt compared to equity, the less susceptible your business is to downturns in economic conditions. It also makes you more attractive to lenders in the event additional financing is needed.

Profitability Rations

Profitability ratios demonstrate how profitable your business is in specific areas of operation. A gross profit margin indicates how sales compare to the cost of goods sold. Assume that your sales for a given period are $10,000 and your cost of goods sold is $6,000. To calculate gross profit margin, subtract the cost of goods sold from sales, which would equal $4,000. This figure is divided by the sales amount, which results in a gross profit margin of 40 percent.

Liquidity Ratio

A liquidity ratio is a comparison of current assets to current liabilities, which is an indicator of your company&amp;#039;s ability to meet short-term obligations. If your current assets totaled $500,000 and current liabilities equaled $400,000, your liquidity ratio would be 5:4. The higher the ratio, the more favorably your business is looked upon by short-term creditors.

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